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Insurance Limits Must be Exhausted by Payment (NY)

Anyone who grew up in the 1980’s is familiar with the “Commodore 64” home computer. The company filed for bankruptcy in 1994, but its directors were recently involved in an interesting case involving excess insurance coverage issues.

In Ali v. Federal Insurance Company, the directors sought coverage under their multi-tier insurance policy. The directors were insured by a “tower” system – namely, each excess policy would be triggered when the limits of the policy below it had reached. The policies contained an “exhaustion” clause which provided that the excess insurance would not apply until all of the underlying limits had been exhausted, “solely as a result of payment of losses thereunder.”

Two of the excess carriers in the tower had become insolvent, including one which had issued an excess policy that contained limits of between $10 million and $15 million. Because the $10 million excess carrier had gone under, the insureds sought coverage under the Federal excess policy that provided coverage in excess of $15 million. The insureds argued that because they were not able to obtain coverage for the amount of liability of $10-15 million, the Federal policy dropped down to cover that amount of liability. The Second Circuit disagreed and relied on the specific policy language that provided coverage where the underlying policies were exhausted as a result of “payment” of the loss, not merely liability above that amount.

In reaching this decision, the Second Circuit also made two interesting points. First, this is limited to the context of third party liability policies, and did not apply to the first party context. For example, an insured seeking coverage for its own property does not have to force a primary carrier to pay him before reaching an agreement with the excess carrier.

Second, the Court noted that if it allowed the upper limits to be exhausted by liability alone, the insured could artificially inflate the structure of any settlement in order to tap into these higher limits, and that the requirement of actual payment afforded the insures some protection against the threat.

Thanks to Mendel Simon for his contribution to this post. If you would like more information, please write to Mike Bono.